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The New Europe: The Financial Crisis

By Anthony Williams

Peolple walking in the street

In 2007 and 2008, the emerging economies of the former communist Eastern Europe appeared impervious to a wave of dire financial news sweeping over the Atlantic from the US mortgage market.

The EBRD region was growing at record levels. Countries had largely embraced democracy and embraced the principles of the market economy.

Eight of the countries where the EBRD was investing – Poland, Latvia, Lithuania, Estonia, the Czech and Slovak Republics, Hungary and Slovenia – had joined the EU in 2004 and were preparing to leave the ambit of the Bank.

It was then all the more shocking when the Lehman Brothers effect hit the transition region almost immediately after its 15 September 2008 bankruptcy.

Confident assertions about the end of the transition period melted away. Growth forecasts were wound back savagely in what ultimately turned out to be the region of the world hardest hit by the crisis.

The EBRD reacted swiftly and decisively to this new challenge. Partly responding to calls from emerging countries themselves, then-President Thomas Mirow sought shareholder approval for a rapid and substantial increase in investments.

While the Bank was finalising plans for a 20 per cent rise in financing for 2009, it was already actively boosting its support for the banking sector in the region.

Financing continued apace. In the first three months of 2009, investments rose 64 per cent to €1.1 billion, a record for any quarter since the Bank’s inception.

But the crisis response was not just about investment volumes. On 23 January 2009, the International Financial Institutions met in Vienna with the European Commission, central banks, and governments as well as supervisory authorities from both eastern and western Europe.

The subject of that meeting was how to avoid a banking crisis that was threatening to erupt in the face of the huge exposure that western banks had built up in the former communist east.

Western banks were under pressure to quit the region as they sought to solve their problems at home. The eastern Europe banking sector would have collapsed had they done so.

EBRD chief economist Erik Berglof and his colleague Piroska Nagy called for a coordinated response to a combination of acute liquidity shortages and major refinancing and recapitalisation needs. Berglof spoke of the need for a “Vienna Club” to deal with the crisis

Out of this meeting was born the European Bank Coordination Initiative. Later known as the “Vienna Initiative,” it provided a unique forum for coordination between the public and private sectors – between the governments and the regulatory authorities from both east and west and the private banks themselves, and also involving the IFIs and the European institutions.

The initiative successfully fended off the potentially lethal impact of what threatened to be uncoordinated policy responses to the global crisis and a massive and sudden deleveraging by cross-border bank groups in emerging Europe.

While the EU reversed its position on bank bailout funds and sanctioned their use for the support of foreign subsidiaries, the parent banks started signing up to commitments, under which they agreed to maintain their exposure across the region and recapitalise their subsidiaries as necessary.

Also within the remit of the Vienna Initiative, the largest multilateral investors and lenders in Central and Eastern Europe – the EBRD, the EIB Group and the World Bank Group – pledged to provide up to €24.5 billion to support the banking sectors in the region and to fund lending to businesses over the following two years.

Towards the end of 2009, it became clear that even though the region had staved off the worst of the crisis, the impact on the countries of eastern Europe had been much more severe than originally imagined.

In September, the EBRD agreed to yet a further increase in 2009 investments – a rise of more than half to €8 billion following an appeal by the Group of 20 nations to international financial institutions to make full use of their capacity in response to the current crisis.

But by then it was obvious that available financial capacity was not enough to tide the region over what was going to be a lengthy recovery.

The EBRD asked shareholders to agree to a 50 per cent capital increase to €30 billion, saying: "There can still be no doubt that the global crisis has hurt the transition economies more than any other region in the world.”

Of the EU 8 countries that had been expected to “graduate” from the EBRD by the end of 2010, only the Czech Republic had done so – in 2007 before the crisis had hit the region. The graduation process for the remaining seven was never formally halted, but it was clearly on hold.

EBRD investments to the EU7 – rather than being steadily reduced to the scheduled trickle – exploded to hit €1.5 billion in 2009/2010.

The capital increase meant the dramatic rise in overall investments to €5 billion before the crisis to about €9 billion at its height could be sustained.

Even at this time, the greater policy coordination, increased investment and targeted support from the IMF and the EU for a number of countries had set the stage for a fragile recovery. Nevertheless, the full social costs in terms of unemployment and the full impact on businesses had yet to be realised.

An embryonic recovery was abruptly interrupted by a new source of crisis – and again from outside the borders of the transition region.

Sovereign debt problems in some eurozone countries had hung over the region’s economy for months but by October 2011 they had reached such proportions that the EBRD’s economists were once again winding back forecasts, especially in central and south-eastern Europe.

Western European banks, having largely maintained their exposure to eastern Europe in the early stages of the global crisis, were now under acute regulatory pressure to strengthen their own balance sheets. The withdrawals from the region that had been avoided earlier were now inevitable.

In January 2012, the Vienna Initiative was galvanised back into action but not to stop the deleveraging, which turned out to be sustained and significant.

Its priorities this time around were to minimise the impact of deleveraging, including by helping to adopt policies that addressed the interests of the countries in the east where the major western banks were active.

And once again the major institutions – the World Bank, the EIB and the EBRD – joined forces to target central and south-eastern Europe with increased funding – a new package of €30 billion.

The financing would be underpinned by increased cooperation to develop policies and implement reforms to strengthen the recovery when it eventually does come.

As the EBRD continues to invest at the new, higher post-crisis levels, this “reform deficit” remains very high up its agenda of priorities.

Highlighted by the Bank’s latest Transition Report 2014: Innovation in Transition this dilemma will focus the EBRD’s work on helping strengthen the institutional framework within which the market economy can flourish for the benefit of all.

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